University of Illinois Urbana-Champaign

Option hedging error in commodity markets

Olson, Ryan Paul

Content Files
OLSON-THESIS-2020.pdf

Permalink

https://hdl.handle.net/2142/109434

Description

Title
Option hedging error in commodity markets
Author(s)
Olson, Ryan Paul
Issue Date
2020-12-07
Director of Research (if dissertation) or Advisor (if thesis)
Sherrick, Bruce J
Committee Member(s)
  • Robe, Michel A
  • Garcia, Philip
Department of Study
Agr & Consumer Economics
Discipline
Agricultural & Applied Econ
Degree Granting Institution
University of Illinois at Urbana-Champaign
Degree Name
M.S.
Degree Level
Thesis
Date of Ingest
2021-03-05T21:38:20Z
Keyword(s)
Options, Hedging, Financial Engineering, Agricultural Economics
Abstract
Hedging options are a common practice to reduce or specify the risk of an option position. In most institutions, it takes place daily. The hedge coefficients used are often determined by the Black Scholes option pricing model and are commonly referred to as the “greeks”. Although the flaws of the Black Scholes model are well known, the model is still extremely useful and the most commonly used approach. The hedge error is defined as the difference in the profit and loss of the option position and the hedge position. Hedging an option reduces the volatility of an option position. In practice, the volatility of the position cannot be reduced to zero. This thesis studies the remaining volatility known as hedge error. This thesis examines how moneyness and tenor affect hedge error in order to help a trader manage the hedge error. Secondly, this thesis investigates which subset of the greeks provides an optimal and economically significant reduction in volatility. Corn, lean hogs, and crude oil are the three commodities that are investigated in this thesis. The results are additionally separated into puts and calls. The results show that as an option is further out-of-the-money, the hedge error increases by an economically significant amount. Second, this research finds only marginal volatility reduction is achieved by hedging rho, interest rate risk. However, incorporating a gamma and/or vega hedge significantly reduces the volatility of the option portfolio returns.
Graduation Semester
2020-12
Type of Resource
Thesis
Permalink
http://hdl.handle.net/2142/109434
Copyright and License Information
2020 by Ryan Paul Olson. All rights reserved

Owning Collections

Graduate Dissertations and Theses at Illinois PRIMARY
Graduate Theses and Dissertations at Illinois
Dissertations - Agricultural and Consumer Economics